IMF: Central Banks Face Steep Losses as They Pull Back

Central banks got it right when they saved the world economy, but their unprecedented actions risk disruptive cross-border spillovers and potentially heavy losses when the time comes to reverse course, the IMF said on Thursday.

In its most detailed survey so far of the dramatic measures taken to counter the damage from the 2007-09 financial crisis, International Monetary Fund staff repeated earlier assessments that the steps had worked but face diminishing returns.

However, in new research, they also said central banks could face severe losses when they begin to withdraw the extraordinary sums of money they have pumped into financial systems around the world.

Massive market bets are riding on whether the U.S. Federal Reserve and its peers can execute a graceful withdrawal from more than four years of ultra-easy monetary policy, which helped restore confidence in global growth.

Central banks have pumped trillions of dollars, euro and yen into the global economy through bond-buying campaigns after interest rates were slashed close to zero.

The ultra-easy monetary policies have prompted critics to warn of the risk of inflation and asset price bubbles, while some developing nations have argued their richer counterparts were seeking to gain an export edge by lowering the value of their currencies.

Jaime Caruana, head of the Bank for International Settlements, warned on Thursday that big central banks should not delay in winding down their economic support programs. The BIS advises global central banks.

But the IMF found the benefits of unconventional measures still outweighed the potential costs in the United States and Japan, and it reserved its toughest language for politicians who fail to undertake long-overdue economic reforms.

"A key concern is that monetary policy is called on to do too much, and that the breathing space it offers is not used to engage in needed fiscal, structural, and financial sector reforms," the IMF said in the report.

"These reforms are essential to ensuring macroeconomic stability and entrenching the recovery, eventually allowing for the unwinding of unconventional monetary policies," it said.

FRIEND OR FOE

The IMF did, however, find evidence to support the claims of central-bank critics that keeping interest rates ultra-low for so long risks future inflation and asset bubbles, with the bond-buying exposing the institutions to potentially steep losses.

It looked at the Fed, Bank of Japan and Bank of England and found all three would face balance sheet losses if they had to sell bonds to quickly shrink their balance sheets.

Losses can also stack up if central banks have to pay interest on excess reserves if those payments exceed earnings from assets held by the central banks. They might want to pay interest to soak up the excess funds so they do not flood into credit markets and cause inflationary stress.

The Fed has tripled its balance sheet to more than $3 trillion through three waves of bond buying and the Bank of Japan surprised markets last month declaring it would drive inflation up to 2.0 percent through asset purchases.

The Bank of England has bought bonds worth 375 billion pounds ($575 billion) so far but opted to not increase that amount when it reviewed policy on May 9.

Under a worst-case scenario, the IMF said losses could top 7.0 percent of GDP for the BOJ, nearly 6.0 percent of GDP for the BOE, and more than 4.0 percent at the Fed. But it stressed that any losses would be mainly a political problem and would not hurt the real economy or prevent the central bank from doing its job.

"Absent actual or feared political interference, however, central bank losses and the size of balance sheets should not constrain the implementation of monetary policy," it said.

SPILLOVERS

Another source of danger lies in the cross-border spillovers of ultra-easy monetary policies that encourage investors to pour capital into higher-yielding emerging markets.

IMF staff acknowledged the risk, but said that so far there was no clear evidence that the costs from spillovers outweighed the benefits of stronger global growth resulting from actions by central banks in advanced economies.

"Thus far, capital flows to emerging markets have been ample, but not alarming," the report noted. "While a number of factors such as high commodity prices and growth imply that these flows could be structural, legitimate concerns about a sudden change in global market sentiment remain."

That said, emerging market authorities can help offset the potential impact of fickle capital inflows, including by introducing caps on how much capital can enter. International policy coordination could also help.

"Outcomes could be improved if policymakers in source countries take into account how their policies affect global economic and financial stability. Greater attention to the cross-border coordination of policies would also help," it said.